« Commonly Used Accounting Phrases/Terms
Principal Tools Used For The Analysis Of Financial Statements »

Differentiating Profit And Cash

[ GO TO THE MAIN PAGE FOR ALL ARTICLES RELATING TO CASH FLOWS]

Sometimes, due to unfamiliarity, some managers particularly those without any accounting knowledge might not truly understand what’s Profit and Cash. For them, profit and cash is alway synonymous. They associate highly profitable companies to be those who are highly liquid or have lot of cash in their coffers. In actual fact, failure to understand this simple principle will cause serious repercussion to the financial health of the company.

Let’s look at the following basic traits of Profit & Cash:

PROFIT:

  • Is when the Income exceeds Expenses (Loss is when Income is lesser than Expenses). Therefore, profit is the residual amount that remains after expenses have been deducted from income.
  • The profit shown in the Income Statement are based on the Accrual and Matching Concepts and not on cash basis. ( Refer to my article on matching and accrual concept )

whereas

CASH

  • Cash is basically cash on hand and demand deposits. Cash equivalents include short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

Append below the major differences between Profit And Cash:

PROFIT VERSUS CASH:-

  • A company makes a profit when its Incomes exceed its Expenses.
  • From the Income side, there are billings to customers that the company have not yet received cash for the goods or services rendered to these customers. In other words, the company is giving its customers credit. Only when the company receive the money from the customers, will that become cash in hand.
  • Similarly from the Expenses side, the company can be owing to the suppliers. The terms with them can be ranging from 7 days to 60 days. So, we don’t need to pay cash to buy their goods or services.

  • Don’t forget that there are some non-cash expenses items in the Income Statements like depreciation which is only an accounting method of allocating costs. (We have earlier used cash to pay for these fixed assets. It is only because of the matching concept that we need to allocate depreciation to the Income Statement.)

So what’s the fuss of differentiating between profit and cash? This is simply because :

  • The Company can be profitable meaning that its has income exceeding its expenses but it might not be liquid or cash rich because as earlier explained, the monies owing by its customers has not be received;
  • The Company still need money to pay all its expenses like the all-important staff/workers salaries and wages, rental, utilities and many others;
  • Hence sometimes, profitable companies can go under because it is not able to stay liquid due to the overextension of credit to their customers

This entry was posted on Sunday, October 14th, 2007 at 3:22 am and is filed under c. Cash Flows. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

One Response to “Differentiating Profit And Cash”

  1. Snapshot Of All Articles Under The Heading Of Cash Flows Statements | MBA Accounting Says:
    March 16th, 2008 at 11:53 pm

    […] The Importance of Differentiating Profit And Cash […]

Leave a Reply